What is a discounted cash flow (DCF) model?

A DCF values a company as the sum of all the free cash it will generate for its owners in the future, converted into what that cash is worth today. You project free cash flow for several years, discount each year back to the present, add a terminal value for the cash flows beyond the projection, and divide by shares outstanding to get an intrinsic value per share.

Why is future cash worth less than cash today?

Because today’s cash can be invested and grow. A dollar received in ten years is worth less than a dollar today, so each future cash flow is divided by (1 + r) raised to the number of years, where r is the discount rate. The further out the cash flow, the larger the discount.

What is terminal value, and why does it dominate a DCF?

Terminal value captures all the cash flows beyond the explicit projection period, assuming the company grows at a slow, perpetual rate forever. It commonly accounts for 60–80% of the total valuation, which is why it is the most important — and most uncertain — assumption. Terminal growth should never exceed the long-term nominal economy growth rate of roughly 2–4% (higher in nominal terms during periods of elevated inflation).

Why does the discount rate matter so much?

The discount rate is the single most powerful input in a DCF. When you discount cash flows to the whole firm, it is usually the weighted average cost of capital (WACC); equity-only cash flows are discounted at the cost of equity instead. A change of one percentage point can shift the valuation by roughly 15–30%, depending on how far out the cash flows stretch, because it compounds across every future year. It is also where models are most often nudged to produce a desired answer.

What is a sensitivity analysis?

A sensitivity analysis varies the two most influential inputs — the discount rate and the terminal growth rate — to show a range of intrinsic values rather than a single point estimate. If the company looks undervalued across most of the table, the signal is robust; if it’s cheap only in the most optimistic corner, the thesis is fragile.

Is a DCF reliable enough to act on?

A DCF is a structured way to make your assumptions explicit, not a precise answer. Small changes in growth, margins, or the discount rate can swing the output dramatically. Its real value is showing what you would have to believe for today’s price to make sense — which is why professionals pair it with relative valuation and demand a margin of safety.

What is WACC, and how do you calculate it?

WACC — the weighted average cost of capital — is the blended return a company’s debt and equity holders together require, and it is the discount rate used for cash flows to the whole firm. You weight the after-tax cost of debt and the cost of equity by their share of the capital structure. The cost of equity is usually estimated with the CAPM: the risk-free rate plus beta times the equity risk premium. A single percentage point of WACC can move a DCF valuation by 15–30%.

Should you subtract stock-based compensation in a DCF?

Yes. Stock-based compensation is a non-cash expense, so it is often added back to reach free cash flow — but it is a real cost, because the company pays employees in newly issued shares that dilute existing owners. Treating it as free overstates owner free cash flow and intrinsic value, especially for software companies where SBC can be a large share of revenue. Subtract SBC from free cash flow, or model the rising share count.

What is a reverse DCF?

A reverse DCF runs the model backwards: instead of turning your assumptions into a value, it fixes the value at today’s market price and solves for the growth rate the market must be assuming. It reframes the question from "what is it worth?" to "what would have to be true for this price to make sense?" — then you judge whether that implied growth is believable against the company’s history. It is the hardest version of a DCF to fool yourself with.

How to Build a DCF Model — Discounted Cash Flow Valuation Step by Step

A company is worth all its future cash — in today’s money

Strip away every multiple, every chart, every headline. The fundamental truth of valuation is this: a business is worth the sum of all the cash it will ever generate for its owners, discounted back to what that cash is worth today.

That’s the entire concept of a DCF — the heart of any fair-value methodology. Everything else is the mechanics of estimating those future cash flows and deciding how much to discount them. Build the intuition first, then build the model.

Project future cash flows
Estimate how much free cash flow the company will generate each year for the next 5–10 years, based on revenue growth and margins.
Discount them to today
$100 next year is worth less than $100 today. Use a discount rate to convert future cash into present value — the further out, the bigger the discount.
Add a terminal value
The company doesn't stop after 5 years. Terminal value captures all the cash flows beyond the projection period, also discounted to today.
Divide by shares → intrinsic value
Sum everything, adjust for debt and cash, divide by shares outstanding. The result is your estimate of intrinsic value per share — compare it to the market price.

The discipline of a DCF

The output of a DCF is never “the answer.” It’s a structured way to make your assumptions explicit. The real value isn’t the final number — it’s that you’re forced to state exactly what you believe about growth, margins, and risk, and then test those beliefs.

Why future money is worth less today

Before the full model, internalize the single most important concept: discounting. $1,000 received in ten years is not worth $1,000 today — because you could invest today’s money and grow it. Formally: PV = FV ÷ (1 + r)ⁿ, where FV is the future cash amount, r is the annual discount rate, and n is years. The discount rate captures opportunity cost. Move the sliders and watch.

Present value calculator

What is a future cash payment worth in today’s money?

Future cash amount$10,000

Years in the future10 yrs

Discount rate9%

Present value (worth today)

$4,224

$10,000 in 10 years is worth $4,224 today at a 9% discount rate.

The formula behind it

Present value = future cash ÷ (1 + r)ⁿ, where r is the discount rate and n is the number of years. This single equation, applied to every future cash flow and summed, is a DCF. Everything else is detail.

The interactive DCF builder

We’ll value a fictional but realistic company — Meridian Software — through four stages. Adjust the assumptions at each step and watch the intrinsic value build up in real time. The final number is yours to defend.

dcf-model · Meridian Software

Current price $165

Start with what the company earns today, then project how its free cash flow grows over the next five years. Meridian generated $17B in free cash flow last year.

Revenue growth rateAnnual, years 1–512%

FCF marginFree cash flow as % of revenue25%

Year	Revenue	FCF
Y1	$76.2B	$19.04B
Y2	$85.3B	$21.32B
Y3	$95.5B	$23.88B
Y4	$107.0B	$26.75B
Y5	$119.8B	$29.96B

What you’re decidingHigher growth means more future cash — but be realistic. Few companies sustain 30% growth for five years. The FCF margin reflects how efficiently revenue converts to actual cash. Software typically runs 20–35%.

The honest truth about DCF

A DCF can justify almost any valuation if you nudge the assumptions. That’s not a flaw — it’s a feature. The point is to see what you’d have to believe for today’s price to make sense. If the price requires 25% growth forever, you’ve learned something important.

How this relates to the Fair Value tool

This lesson builds the full method: project the whole company’s free cash flow, discount it to an enterprise value, then bridge to equity value per share. TickerLeague’s Fair Value methodology uses a faster per-share variant — it discounts earnings, or free cash flow per share, directly. The discounting and terminal-value math are identical; the per-share version trades a little rigor for speed so it can run automatically across thousands of companies.

A worked example — Meridian Software

Using the base-case assumptions from the builder above (12% FCF growth, 25% margin, 9% WACC, 2.5% terminal growth), here is how the four steps flow through to an intrinsic value.

01Project 5-year FCF12% annual growth · 25% FCF marginUndiscounted total: $121.0B
02Discount each year at WACCPV = FV ÷ (1 + 9%)ⁿ — each year gets its own factor; Year-5 factor: 0.650PV of FCF: $92.3B
03Add terminal valuePerpetual growth at 2.5%, discounted to todayDiscounted TV: $307.1B (77% of EV)
04Equity value per share($399.3B EV + $27B net cash) ÷ 2.5B shares≈ $171/share

The base case yields an intrinsic value of approximately $171/share. But that number depends entirely on the inputs — a one-point shift in the discount rate moves it materially. The sensitivity table below shows the range across the three most common discount-rate and terminal-growth combinations.

Terminal growth ↓ / WACC →	8%	9%	10%
2%	$187	$161	$142
2.5%	$201	$171	$148
3%	$217	$181	$156

Base case (9% WACC, 2.5% terminal growth) highlighted in brand color. All figures are intrinsic value per share in USD.

Sensitivity analysis — because one number is a lie

No professional presents a single DCF output. They present a range, built by varying the two most sensitive inputs: the discount rate and the terminal growth rate. This table shows how Meridian’s intrinsic value shifts across that range.

Intrinsic value per share — sensitivity table

Discount rate (columns) × terminal growth (rows), shaded by deviation from the base-case value.

TV growth ╲ WACC	7.0%	8.0%	9.0%	10.0%	11.0%
1.5%	$208	$176	$153	$136	$122
2.0%	$224	$187	$161	$142	$126
2.5%	$244	$201	$171	$148	$131
3.0%	$270	$217	$181	$156	$137
3.5%	$303	$236	$194	$165	$144

How to read it

The spread between the corners tells you how much your conclusion depends on assumptions. If the value holds up across most of the table, that’s a robust signal. If it only works in the most optimistic corner, your thesis is fragile — proceed with caution and demand a margin of safety. Try the same four steps on a real company in the Rankings.

Where the discount rate actually comes from — WACC

Every model so far asked you to pick a discount rate. Professionals don’t guess it — they build it. When you discount cash flows to the whole firm, the rate is the weighted average cost of capital (WACC): the blended return that debt and equity holders together require to fund the business.

WACC = (E/V) × Re + (D/V) × Rd × (1 − tax)

Debt is the easy half — roughly the interest rate the company pays, made cheaper by the tax shield. The hard half is the cost of equity (Re), which has no invoice. The standard estimate is the Capital Asset Pricing Model (CAPM):

Re = Rf + β × ERP

Rf is the risk-free rate (the 10-year government bond). ERP is the equity risk premium — the extra return investors demand for stocks over bonds (historically ~4–6%). Beta (β) scales that premium by how much the stock moves relative to the market: a β of 1.3 means ~30% more volatile, so investors demand ~30% more premium.

Put real numbers on it. Here is an illustrative cost of capital for Adobe (ADBE) — rounded figures, roughly 2025, for teaching rather than a live quote:

Risk-free rate (10Y)	4.2%
Beta (β)	1.30
Equity risk premium	5.0%
Cost of equity = 4.2% + 1.30 × 5.0%	10.7%
WACC (Adobe is ~all-equity funded)	≈ 10.5%

Why this is where models get gamed

The sensitivity table showed a single point of discount rate swings the valuation 15–30%. WACC isthat input — so it’s where an analyst who wants a stock to look cheap quietly shaves off a point. Build it from CAPM and defend each input, rather than reverse-engineering the rate that gives the answer you already wanted.

The cost everyone “adds back” — stock-based compensation

Open almost any published DCF and you’ll see stock-based compensation (SBC) added back on the way to free cash flow, because it’s a non-cash expense. For modern software companies, that one move is the most common way intrinsic value gets quietly inflated.

SBC is not free. The company pays employees in your ownership — newly issued shares that dilute your stake every year. Cash didn’t leave the building, but value left your slice of it. Counting SBC as a non-cost treats a real expense as zero and overstates owner free cash flow.

The fix is simple: subtract SBC from free cash flow (or model the rising share count). On a high-SBC business the gap is not a rounding error — here it is, illustratively, for Adobe (rounded, ~2025):

Reported free cash flow≈ $8.0B
Less: stock-based compensation− $1.8B
Owner free cash flow≈ $6.2B

“Add-back” FCF is a salesman’s number

Using $8.0B instead of $6.2B overstates the cash that actually belongs to owners by roughly a quarter — and a DCF compounds that error across every future year. For any company paying a large slice of comp in stock, treat SBC as the real expense it is.

Reverse DCF — what the price is already telling you

A forward DCF turns your assumptions into a value. A reverse DCF runs the model backwards: it fixes the value at today’s market price and solves for the assumptions the market must be making. Instead of “what is it worth?”, you ask “what would have to be true for this price to make sense?” — a question that is far harder to fool yourself with.

Take the current market value, your WACC and margins, and back out the one number left free: the free-cash-flow growth rate that exactly justifies the price. Then sanity-check it against history and reality.

Adobe, illustratively

At roughly its 2025 market value, a ~10.5% WACC, and owner free cash flow near $6B, Adobe’s price implies something like low-double-digit free-cash-flow growth sustained for a decade. The question is no longer “is the DCF right?” but “does a maturing company keep compounding cash in the low double digits for ten years?” If you can’t defend that, the price — not your model — is the aggressive one.

This is the most honest use of a DCF. It converts an unanswerable question (“what is the exact value?”) into a testable one (“is the implied growth believable?”), and it kills more bad theses than any forward model — which is why it pairs naturally with a margin of safety.

Check your understanding

0/3 answered

01/ 03

In a DCF model, you increase the discount rate from 8% to 10% while keeping everything else the same. What happens to the intrinsic value?

02/ 03

An analyst’s DCF shows a terminal growth rate of 6% in perpetuity. Why should this immediately concern you?

03/ 03

Your DCF produces an intrinsic value of $180; the stock trades at $165. The valuation only stays above $165 in the most optimistic corner of your sensitivity table. What’s the right conclusion?

Building a DCF model from scratch